The End of U.S. Equity Leadership?

Emerging market (EM) equities outperformed the global benchmark significantly in 2016, 2017, and the first quarter of 2018. In the second and third quarters of 2018, however, trade wars, an associated souring of investor sentiment, outflows, and falling currencies caused EM stocks to deviate far below levels justified by generally stable economic fundamentals. However, we believe that much of the bad news has already been priced in, so investors shouldn’t get too pessimistic on EM shares.

In fact, we think that now is a good time to get into EM equities. After heavy selling pressure, EM stocks are up from their late October 2018 lows. History shows that bull markets are born in despair, and die in euphoria; we appear to be closer to the former than the latter. Similarly oversold extremes in the late 1980s and early 2000s were followed by multi-year periods of EM outperformance. If past is prologue, this could be another one of those episodes. Exhibit 1

Is U.S. Dollar Strength a Headwind for EM Stocks?

Yes, U.S. dollar (USD) strength has been a headwind for EM equities, and 2018 was no exception. In a global context, currency dynamics are an important component of investors’ total returns. USD strength and EM currency weakness—by definition—erode dollar-based investors’ returns.

As foreign capital fled from EM stocks, EM currencies were sold in exchange for foreign currency-denominated assets. After a short period of redemptions, however, flows have returned to EM stocks. Improving fundamentals versus 2015/2016 have made EM less vulnerable to capital flight as the U.S. Federal Reserve (Fed) raises interest rates gradually.

Looking ahead, we believe that the USD is unlikely to remain an obstacle for U.S.-based investors, as the currency faces challenges in the form of ballooning fiscal and current account deficits, overvaluation, and overbought extremes that warn of a structural bear market for the greenback. Exhibit 2

The Convergence of U.S. and Chinese Equities

When we think about 2018 and the outlook for 2019, in our view, it’s about the divergence and convergence of the two largest economies in the world, the United States and China. Specifically, 2018 was characterized by U.S. equity and economic leadership (i.e., divergence), spurred by massive fiscal stimulus and tax cuts. However, that started changing in October (i.e., convergence) as investors began anticipating the fading benefits of fiscal policy coupled with the negative effects of tightening financial conditions. Exhibit 3

Meanwhile, the outlook for China is brightening after a period of policy austerity.

Fiscal policy is easing: The authorities are cutting tax rates for consumers and businesses in January, which should widen the deficit and stimulate the economy.

Monetary policy is easing: Policymakers are lowering the required deposit reserve ratio, injecting liquidity into the banking system and reducing interbank rates.

The renminbi (RMB) is weakening: The currency is a powerful economic shock absorber that helps offset trade tariffs, lowers costs, and makes China more competitive.

Like 2016 and 2017, we expect 2019 to be known as another year of Chinese equity and economic leadership, helped by policy stimulus and easing financial conditions.

Concerns About U.S. Tightening Are Valid

In the United States, concerns about the impact of tightening financial conditions are valid. There has been a strong inverse relationship between changes in the Goldman Sachs (GS) U.S. Financial Conditions Index and the Institute for Supply Management (ISM) Manufacturing Purchasing Managers Index (PMI) since 1996. Together, Fed interest rate hikes, higher 10-year Treasury bond yields, a stronger USD, wider corporate bond spreads, and falling stock prices are headwinds for economic growth. In our view, the Fed should back off before it makes a policy error and pulls forward the end of the current expansion by raising interest rates too much.Exhibit 4

Gathering Tailwinds for China’s Growth

In China, the positive effects of easing financial conditions seem to be underappreciated by investors. Since 2009, there has been a notable inverse link between changes in the Yicai Research Institute (YRI) China Financial Conditions Index and the Caixin China Manufacturing PMI. Low interest rates, accommodative financing conditions, and access to credit—the lifeblood of an economy—are tailwinds for growth. Exhibit 5

In short, our favorable view of Chinese and EM shares depends largely on a pickup in global growth led by China. Just as slowdowns can be engineered in a command economy, so can re-accelerations. That’s why we believe the good things that happened in the U.S. last year will happen in China this year. Stay tuned.

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